Capitalization of reserves approach for M&A transactions

The profit compensation mechanism (PCM) for M&A transactions of listed companies does not seem to be producing the desired effect for which it was designed, as revealed by breaking news about overvaluation of targets, sharp performance declines upon deal closing, and inability to deliver on the profit compensation commitment. This article provides insight into problems with the PCM, and proposes capitalization of reserves as an approach to distributing post-M&A excess profit.

Problems with existing PCM. Being an essential part of an M&A programme, the PCM is ultimately aimed at achieving a win-win outcome between the listed company and the target in the long run. In the medium term, it is designed to prevent damage to interests of the listed company and its (small and medium) investors. However, direct profit compensation seems to fail in both objectives. As the ultimate objective is concerned, instead of helping to achieve a long-term win-win outcome, the mechanism brings only short-term interests, whether the compensation is provided in the form of bonus share or cash.

Worse still, it sets the scene for potential confrontation between the two sides at the very beginning of the deal process. As the medium-term objective is concerned, interests of the listed company and its (small and medium) investors cannot escape damage even if the existing PCM is enforced to the fullest extent. Let’s see how this mechanism works with a simplified algorithm using the formula for share-based compensation encouraged by regulators and earnings per share (EPS), a frequently mentioned indicator of investor protection.

Gong Ruozhou is an associate at Grandway Law Offices